Heavily indebted Canadian households about to feel the effects of the rate hike

One of the world’s largest economies is handcuffed to over-indebted homebuyers. An Oxford Economics analysis examines two scenarios for rate hikes in Canada. Tony Stillo, the company’s chief economist, expects the Bank of Canada (BoC) to slowly raise interest rates. If the central bank follows this path, all households will bear the brunt of higher inflation. However, the mortgage repayment would see a minimal increase. If the central bank pursues a more aggressive program to fight inflation, households will feel a bigger pinch.

Canadian households owe $ 2.5 trillion in debt

Canadian households have accumulated mortgage debt during the pandemic. Total household debt reached $ 2.5 trillion in the third quarter of 2021, driven by $ 193 billion in mortgage debt since the fourth quarter of 2019. Mortgage debt accounts for 68.7% of household debt in Canada , up 4 points compared to the same period. Households accelerated their mortgage debt during the pandemic. It could cost them a lot more than expected in just a few months.

BoC plans to hike rates slowly and embrace high inflation

Oxford Economics has forecast one of the less aggressive rate hike schedules. They see the current rate of 0.25% to be maintained until the fourth quarter of 2022 and gradually increase to the “neutral” level of 2% by mid-2026. This is a very slow increase and unlikely to solve the inflation problems.

The company sees the BoC adopt higher inflation to keep debt holders comfortable. What would be the swell, right? If you haven’t borrowed as much as you can, your reward is seeing your purchasing power plummet. In a way, households would subsidize indebted households to make payments more manageable.

Stillo estimates a very manageable increase in the average payout in this scenario. They estimate that the debt service ratio (DSR) would drop from 6.3% in the third quarter of 2021 to 8.2% in the fourth quarter of 2023. This would be the same level of load as in 2018-2019 during the last BoC rate hike.

The company estimates that the average mortgage payment would increase by $ 86 in Q4 2023 and $ 236 in Q4 2026. Not exactly shocking, but not insignificant. If a median 30-year-old diverted that money from their retirement planning, it would create a shortfall of $ 200,000 by the age of 65. Small changes can have a big impact. This is the reason why people lend money, however.

If the BoC rises to curb inflation, indebted households will pay a lot more

Canadian households will be exposed to much higher debt repayments if the BoC tries to fight inflation. They expect the central bank to start raising rates early next year under this scenario. Interest rates would hit the neutral zone of 2% in mid-2023, more than three years earlier than in the ideal scenario. The more aggressive schedule is more in line with the forecasts of financial institutions.

Aggressive increases to curb inflation would lead to a sharp increase in the debt burden. Households would see their DSR exceed the peaks of 2018-2019 during the latest rate hikes in the fourth quarter of 2022. In the fourth quarter of 2026, we could see the DSR reach 10%, which corresponds to the high before the global financial crisis . The average mortgage would increase by $ 166 by the end of 2023 and “… put a strain on household finances.”

When most people hear “straining household finances” they think of mortgage defaults. Hell breaks loose and the world ends. This is not the case. These heavily indebted households would likely be content to reduce their consumption.

Reduced consumption seems terrible until you realize it happens in either scenario. If indebted households do not reduce their consumption because of higher rates, inflation remains high. If inflation is high, everyone reduces their consumption as purchasing power declines. Extend low rates to save heavily indebted households, or prevent the entire population from taking a hit? A tough guy, I know.

With inflation being such a widespread problem, that is why institutions are betting on the hike soon. The National Bank of Canada (BNC) said the recovery would be in jeopardy if rates do not rise in the next quarter. Scotiabank has also forecast eight rate hikes over the next two years. It’s similar to Stillo’s aggressive storyline. Either way, it might be time to redesign that budget if you’ve recently been the victim of a mortgage debt frenzy.

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